Regulation and Net Neutrality Michael Kotrous* JEL Codes: L43, L90, L14 Keywords: Regulation, Market Structure, Net Neutrality Abstract: This paper seeks to inform the network neutrality debate by looking at the role existing government regulation has played in shaping the market for broadband access. Prior research has concluded that network externalities that exist in the market for broadband services justify government intervention (Economides and Tag, 2012). This literature takes limited competition among broadband providers as given rather than questioning why competition is limited in the first place. I argue here that limited competition among broadband providers is not the result of a market failure but rather stems from barriers to entry erected by government regulation, notably municipal “rights-of-way.” The key to improving consumer welfare is therefore not to impose additional regulations on broadband providers, but to clear the way for capital investments in the expansion of new infrastructure and the improvement of existing infrastructure by removing existing regulatory barriers to entry. I conclude that deregulation rather than more regulation would improve Internet access and result in a more level playing field for all content providers. * Creighton University, Institute for Economic Inquiry, 2500 California Plaza, Omaha, NE 68178, [email protected] In the past few months, the Federal Communications Commission (FCC) has received nearly 4 million public comments on its proposed revisions of its "Open Internet" rules, also known as "network neutrality" (Gayomoli, Nov. 10, 2014). Network neutrality is the principle that all Internet traffic be treated equally (FCC, “Open Internet”). President Obama recently added comment to the subject in a statement issued on Nov. 10, 2014. He called for the FCC to reclassify broadband as a public utility, which would subject Internet service providers to greater government oversight, including network neutrality rules (Gayomoli, Nov. 10, 2014). The president’s statement highlights the main line of argument provided by the regulation’s advocates: network neutrality prevents Internet providers, which have monopoly power in the regions they serve, from extracting rents from content providers and Internet consumers to the detriment of both. Network neutrality advocates raise two main concerns about the current practices of broadband providers with monopoly status. The first is that broadband providers will erect barriers that reduce the innovation of Internet content by charging content providers to access their networks of subscribers. Forcing website and application developers to pay a so-called “toll” to reach consumers is a practice that regulators fear will favor incumbent content providers like Google and hamper innovation by newcomers to the market. The second concern is anticompetitive behavior by broadband providers in which broadband providers throttle or, in extreme cases, completely block the online services of competitors. Such an extreme case of anticompetitive behavior has required government intervention in North Carolina. A telecommunications firm named Madison River blocked its Internet subscribers from accessing VoIP services like Vonage in an effort to protect its telephone services from Regulation and Net Neutrality Kotrous 2 online competitors. In 2005, Madison River paid a $15,000 fine to the FCC and agreed to stop its discriminatory network management policies (McCullagh, Mar. 3, 2005). Business practices like those by Madison River raise great concern, and justifiably so. The discrimination of data by broadband providers purely for the purposes of raising profits is of great detriment to consumers and content providers. Extortions of rent from consumers and content providers can only be sustained in a market in which broadband providers either do not face sufficient competition or collude with competitors to increase profits. The diagnosis of the problem with the Internet–lack of competition among broadband providers–is correct; the proposed solution of network neutrality rules is incorrect. This paper examines the forces that have shaped the market of Internet service to its current state of limited competition among broadband providers. Previous economic literature on network externalities that affect the supply of Internet content and the demand for Internet access provide support for network neutrality regulation (Lee and Wu, 2009; Economides and Tag, 2012), but these papers assume limited competition for broadband services instead of questioning why competition is restricted in the first place. My research finds that government regulation has stifled competition among broadband providers. The solution to correcting the losses in consumer welfare in this heavily regulated market is not the enforcement of network neutrality regulation but rather deregulation of the construction of Internet infrastructure. My paper begins with a review of network neutrality and the previous economic literature that analyzes the Internet as a two-sided market with considerable network externalities. I then consider the role government regulation has had in establishing Internet providers as monopolies before giving my concluding remarks. Regulation and Net Neutrality Kotrous 3 The Changing State of Network Neutrality The network neutrality principle dictates broadband providers make a “best effort” to transmit data on their networks on a first-come, first-served basis (Brito and Ellig). It has guided the activities of content and broadband providers since the origin of the Internet. Without coercion by government rule-making, broadband providers have sustained “neutral” network management policies for many years, even past the turn of the century (Becker et. al, 2010). The current push for legally enforceable network neutrality regulation is motivated by a growing concern that insufficient competition among broadband providers will result in market failure (Becker et. al, 2010; Hahn and Wallsten, 2006). Figures 1 through 3, below, show the limited amounts of competition among “wired” broadband providers, especially in areas outside major metropolitan areas. Figure 1: The areas highlighted in green represent areas with between one and six wired broadband connections available (source: NTIA and FCC, http://broadbandmap.gov). Regulation and Net Neutrality Kotrous 4 Figure 2: The areas with between two and six wired broadband providers available (source: NTIA and FCC, http://broadbandmap.gov). Figure 3: The areas with between three and six wired broadband providers available (source: NTIA and FCC, http://broadbandmap.gov). Without competition, consumer advocates and regulatory watchdogs fear broadband providers will change their network management policies to extract increased profits from consumers and/or content providers at the detriment of both (Becker et. al, 2010). Evidence of these shifts in the market has already appeared. Recent agreements made between content providers and broadband providers suggest the network neutrality principle that governed the Internet for decades has come undone. Regulation and Net Neutrality Kotrous 5 For instance, the online video streaming service Netflix came to terms with Comcast on a deal for data prioritization in February 2014 (Wyatt and Cohen, Feb. 23, 2014). Figure 4 shows a sharp uptick in Netflix download speeds for Comcast subscribers after the deal was reached. Network neutrality advocates likened this situation to the Madison River case and saw Comcast’s demand for Netflix to pay for improved service as an extortion of rent by a firm with too great market power (The Washington Post, Apr. 25 2014). Figure 4: The bold line shows the steady decline leading up to and the sharp uptick in Netflix download speeds for Comcast subscribers following a deal between Netflix and Comcast in which Netflix paid for data prioritization, which is seen as a violation of network neutrality principles (source: The Washington Post, Apr. 25, 2014). The proposed rules under consideration by the FCC aim to prevent future extortions of rent. Network neutrality rules effectively act as a price regulation preventing broadband providers from collecting fees from content providers for access to broadband subscribers (Hahn and Wallsten, 2006). One provision of network neutrality regulation is the “no-blocking” rule: broadband providers are not allowed to Regulation and Net Neutrality Kotrous 6 block or throttle (slow down) any packets on the basis of what the content is or from which content provider data comes. All content providers must be guaranteed “a minimum level of access that is sufficiently robust, fast and dynamic for effective use by end users [consumers] and edge [content] providers” (FCC, “Open Internet NPRM,” May 15, 2014). In addition, proposed network neutrality regulation dictates broadband providers cannot accept a premium payment from content providers for prioritization of their data, described in the rhetoric as a so-called “fast lane” (FCC, “Open Internet NPRM,” May 15, 2014). The economic justification provided for network neutrality rules relates to the fact that the Internet is a two-sided market, in which Internet providers act as “middle men” between content providers and consumers. Lee and Wu (2009) explain that Internet access, like other two-sided markets, is greatly benefited by positive network externalities. Setting to zero the price broadband providers can charge content providers for access to their “last